From Inflationary Boom to Deflationary Bust

Why the Silicon Valley Bank Crisis is a seminal event into a new economic era

In last week’s post I described how several adverse dynamics now align for the US economy to create a cliff-like moment where economic activity markedly drops. These include depleting consumer excess savings, in particular for the “lower 80%”, a slowdown in previously elevated goods demand and likely higher unemployment from overstaffed cyclical sectors. This all coincides with monetary policy that is historically tight for the current stage of the economic cycle. Silicon Valley Bank (SVB) is the first major casualty of this policy stance. Its demise likely accelerates the economic downturn

The acceleration is less due to SVB’s case itself, which has been solved with the government bailout. It is because this episode alerted millions of Americans to the fact that (1) their deposits pay nothing and (2) are possibly unsafe. This realisation increases deposit costs especially for US regional banks, and in turn lowers their willingness to lend. The result is a classic credit crunch which likely amplifies the deflationary trends already underway

Thus, after a wild inflationary boom, the US is now likely headed for a deflationary bust. Money supply will contract sharply in the coming months while the economy slows and unemployment likely increases, with deflationary CPI prints likely by H2. I’ve sketched this out in many previous posts (see here, here or here). With every month, the contours become more pronounced

This outlook is also the key reason for my decision to invest in US Treasuries, where the patient wait to enter paid off with top-ticking the recent high in yields, to be followed by a historic bond rally

Today’s post explains what I see as pertinent dynamics from the SVB crisis into the deflationary bust, and as always closes with an outlook on current markets

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Let’s start with how we got here, to the second largest bank failure in modern history after Washington Mutual in 2008

• Indeed, we have to go back to said Great Financial Crisis, when Quantitative Easing rose to prominence, the practise of Central Banks buying assets such as bonds or mortgages from asset owners in exchange for cash, thereby driving asset prices up (please see details in this previous post)

• Initially an emergency measure, in 2010 Fed Chairman Ben Bernanke elevated QE to a permanent feature in the Central Bank tool box. To stimulate a sluggish economy at the time, he explicitly targeted QE’s “wealth effect”:

Source: Ben Bernanke, Op-Ed in Washington Post, 5th Nov 2010

• Needless to say, asset owners did not spend more, as they already had plenty of savings. Instead, QE priced lower-income groups out of asset ownership (e.g. homes) and generated much social discontent

Irrespectively, over the next ten years, QE went into overdrive, and during Covid alone $5tr were printed by Central Banks. Due to the Tech boom, much of this money ended up in Silicon Valley, with SVB as its bank

• The SVB bankers were overwhelmed by the deposit flood coming through their doors. With insufficient demand for business loans, they put much of this cash into mortgages at rock-bottom, fixed rates

• Then, interest rates and with it deposit costs started to rise. Further, SVB’s clients, amongst them 55% of America’s start-ups, burned more cash, both leading to a decline in deposits

• Eventually, SVB had to do an emergency capital raise. In a prime example of reflexivity in financial markets, this alerted SVB’s customer base to the imbalances at hand, so they pulled their money, thereby making the situation much worse - $42bn or 25% of SVB’s deposits was withdrawn in one day

As these proceedings made headlines, other depositors at both SVB and similar US regional banks got nervous. They wanted to take their money out, too. Without intervention, a banking crisis was in the cards

• That crisis was averted by the US government over the past weekend. It shut down SVB and Signature bank, a smaller but equally weak peer, guaranteed all deposits (not just the legal $250k minimum), and introduced a facility where banks can fund themselves at very favorable terms

Today’s post focusses on the repercussions of this episode, rather than a judgement of the de-facto bailout, so just a few words on the latter:

• The government’s actions were right from a short-term economic view. Any deposit default would have lead to a panic amongst clients of most US regional banks. Bank runs would have ensued, leading to severe financial instability

• Further, no one can expect SVB’s small business clients to understand bank counterparty risk, if even Wall Street analysts don’t understand it. Many hard working entrepreneurs trusted the soundness of America’s banking system and would have been the “sacrificial lamb”

However, it was wrong from a moral, and long-term economic view

• Once again, a crisis was solved with a bailout and no one had to feel any pain. Once again, the increased sensitivity of risk to the collective economic mind was avoided, to be paid by future generations acting more carelessly and needing ever greater bailouts - thus, entrenching the much quoted “moral hazard” even further

• More so, SVB was a poster child of moral hazard itself. A toxic loan book, complete absence of risk management, lax KYC rules, discounted loans in exchange for exclusive client business - in summary, a reflection of the bailout culture of the past decade, and all under the eye of a sleepy regulator. The defaults on their loan book, much of which funded VC acquisition leverage, will now be paid by the tax payer (!)

The true issue is that after 40 years of ever higher debt levels Western economies are so fragile that the unassisted failure of the US’ 16th largest bank would have been enough to bring everything down

Either way, the bailout happened and the situation is now solved, is it? Unfortunately, no

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Why are things not solved despite the bailout? Two reasons:

• First, over the past week, millions of Americans were made acutely aware that their deposits might be unsafe

• Second, they were also made aware that these deposits don’t pay anything, in contrast to alternatives which pay 4-5% (e.g. money market funds)

Consequently, many are now looking to move their money, especially if they are with one of the “unsafe” US regional banks. What has been seen, cannot be unseen. The emperor has no clothes

• This caused the intense bid for US Treasuries after the weekend, we’ll see retail money market fund flows with some delay

• Money centers such as JP Morgan or Citigroup have been “inundated” with money pulled from regional banks. Large banks benefit from tighter regulation and an overflow of reserves (another QE legacy)

But why is this deposit flight from US regional banks bad for the economy? It’s simple: In aggregate, these banks are a critical credit provider to the US economy

• 37% of all bank lending, 28% of corporate, 53% of residential and 67% of commercial real estate lending is done by US regional banks

Due to the SVB crisis, they now need to (1) pay more for deposits and (2) assume that their deposit base is less sticky than thought. What does that mean?

• Particularly the higher deposit cost is a challenge. After a decade of low rates, the regional bank asset side is stuffed with low yielding exposure, even if parts are floating or hedged

• As the chart below shows, if these banks were to pay market rates for deposits to prevent the flight, they would be deeply loss making. (NB: This would still be the case for many even at e.g. a 2% spread to FFR)

• In addition, should a hard landing materialise, loan losses are likely significant, to weigh further on profitability. Just think of the commercial real estate exposure mentioned before

What does a stressed, unprofitable bank do? It reduces risk. How does a bank do that? By tightening lending standards and cutting back on new credit

• I’ve shown the below chart before. Even before SVB lending standards were near historically tight, imagine where they’ll go in the coming weeks

• Importantly, the deposit issue is made worse by QT, which overproportionally destroys small bank deposits and which I previously discussed here

Now, the big question is, how did we even end up in this bizarre situation, where banks could get away with paying nothing on deposits, while the Fed Funds rate is at 5%?

• As I laid out in “Incentives and Inequality”, the reason can again be found in QE. As Central Banks flooded asset owners with cash in exchange for bonds and mortgages, this created trillions of new deposits (and reserves at large banks - please see same post for technical details)

• Thus, deposits were not a scarce resource and banks felt no need to compete for them. And when rates increased dramatically last year, they could rely on the unawareness of many retail investors to higher yielding alternatives

Source: Kang-Landsberg, Plosser, New York Fed. Own annotation since late 2021

Summary: The SVB crisis laid bare a fragile equilibrium caused by QE that only existed due to people’s unawareness. The veil has been pierced, and now deposit costs are going up while at the same time their stickiness goes down. As a consequence, credit available to the US economy will be constrained further, from already very tight levels - a classic credit crunch

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Now, why is that deflationary, and why does it amplify already existing deflationary trends?

• Inflation is, amongst other things, driven by the amount of money available. This is why the Fed is committed to slowing the growth of money. It achieves this by increasing interest rates, which slows credit creation, and by conducting QT, which indirectly transfers money from the private sector to the government

The Fed’s medicine is working, if we look at the evolution of deposits, or simplified, the money people have available to spend

• While last year $1.2tr net new loans were created, Fed policies offset this growth in new money entirely, so it did not fan inflation further. NB: ‘22 loan growth was driven by lower rates earlier in the year, and revolvers drawn by corporates who lost access to high yield markets

However, since the beginning of ‘23, deposit decline went into overdrive. Why? Loan growth is now negative and QT continues at the same pace

Keep in mind, this data is before SVB happened (!), what will it look like over the next few months? Four dynamics drive the credit crunch from here

• First - Two banks have been shut with a combined $300bn balance sheet. These financiers cannot be replaced from one day to the next, e.g. as former clients need to onboard somewhere else. SVB typically insisted to be the sole banker in exchange for favorable loan terms, Signature had a stronghold in NY commercial real estate

• Second - US regional banks will curtail lending due to more costly and more unstable deposits, as laid out above

• Third - Increased regulation as a belated answer to the crisis will curtail regional bank activity

• Forth - Less lending will lead to higher loan losses, which damages banks further and leads to less lending → a self re-inforcing spiral

Now, looking at a broader monetary picture, M2 (of which deposits are part of) is currently shrinking year-over-year (!). This is important as M2 leads inflation by 1.5-3 years¹

• This historic anomaly only occurred before in 1931, 1921 and the late 1800s, all periods of crisis

In comparison, the often referenced 1970s saw entrenched inflation mainly as a consequence of several bursts of M2 Money Supply growth

Finally, we have to remember that this credit crunch coincides with an increasingly ailing consumer, as recent near-time retail data continues to confirm

Conclusion:

• The SVB crisis will lead to tighter credit standards and lower credit growth than already the case. The dynamics resemble a credit crunch that is deflationary as it shrink the amount of “money” in the economy

• At its origin lie decades of misguided monetary policy, with QE at its heart. The same monetary policies created the post-Covid consumer boom that is now abating, to coincide with said slowdown in credit creation

• The US economy faces enormous headwinds that just intensified with SVB. It likely soon needs renewed provision of liquidity to fight of a deflationary bust

• With the Fed looking to fight the inflation fires in the rear view mirror, this liquidity provision likely only comes when much more damage is done. And looking at past recessions, a tremendous amount of liquidity is likely needed to turn the ship around

Source: Goldman Sachs

At the same time, the economic structure has indeed changed, and whenever new liquidity is provided (which is still far off!), a resurgence of inflation is likely. I’d expect this to take place in 1H‘24 (?), with deflation until then

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What does this mean for markets?

As always, below is my personal attempt at connecting-the-dots for my own investments. Please keep in mind - I may be totally wrong, nothing is more important than risk management, and none of this is investment advice

As today’s article explains, banks are the lifeblood of modern economies, and when they stop functioning, the remainder of the economy eventually follows

Florian Kronawitter @fkronawitter1

🇺🇸 A very simple chart - what will happen to your economy when your banks do this 👇 https://t.co/0wlM7O0jLz

In a deflationary bust driven by contracting credit, the economy is in urgent need of liquidity. For that reason, everything will be sold, from stocks to houses to commodities to crypto to gold, in exchange for US Dollars and US Treasuries, the foundational layers of the world economy

• This is why I am max long US Treasuries across the curve, as detailed last week. I also notice that hedge funds were once again on the wrong crowded side of this trade and thus fuelled the bond rally with record short covers

The deflationary bust is likely solved by a return to QE or some similar measure that provides liquidity to markets again (in Q4?). When that happens, all asset prices rise again, until inflation returns (1H’24?) and interest rates increases follow. For the avoidance of doubt - the moment of liquidity provision is not near!

Just as I’ve patiently waited to enter Treasuries at the right moment, I’m now equally patiently waiting for the right moment to to short equities again, as I expect a steep sell off in all risk assets once economic data confirms the “hard landing” I anticipate

• Equity positioning is very bearish, which keeps me from applying shorts. As things are moving fast, this means I might miss the drawdown. Either way, long bonds and short equities has now become the same trade, something also discussed in last week’s post

• I am however short levered loans via the SLRN and BKLN ETFs. These products have very limited upside and massive downside, should a hard landing materialise. I see levered loans as one of the epicenters of this crisis, see this post from December ‘22

There is a decent chance that the Fed pauses interest rate increases at next week’s FOMC. Financial conditions tightened to the equivalent of a hike, and it appears unwise to raise rates into a deflationary banking crisis. My sense is that emergency cuts will follow by the summer, and we will see much lower rates later this year. These will likely show limited traction as the economy does not want more debt. Thus I expect a return to QE or another, similar liquidity provision by the end of the year. Until then, the outlook for risk assets is - in my view, which may always be wrong - very difficult

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1. The M2-inflation relationship is clearest in extremis and when controlling for regulatory changes (e.g. changed banking regulation in early 1990s) and credit growth (e.g. credit shrunk post GFC and with it money velocity, offsetting M2 growth)